Stuck on the Methodological Hamster Wheel

I’ve read John Cassidy’s New Yorker article (not available online) in which he described his journey to the freshwater provinces in his attempt to see whether the financial crisis had caused Chicago economists to reject their reactionary views. (With one exception, the answer is blessedly “no.”) I’ve also read his paean to Pigou in the WSJ. So I pretty much knew what to expect when I picked up his How Markets Fail. Let’s say I wasn’t disappointed, in the sense that my very low expectations were met.

The book is a very conventional, Stiglitz-esque critique of market economics and those who defend markets. The latter are always described with Homer-esque modifiers, just so you’ll know that they [we!] are retrograde knuckle draggers.

I won’t go into gruesome detail (and the details are gruesome), but a couple of things deserve mention.

The first is that Cassidy follows his chapter on Hayek with a chapter on Arrow-Debreu models of perfect competition, and claims that the latter is a formalization of the former. You can see where this is going, right? Since the Arrow-Debreu assumptions don’t hold, perfect competition is unrealistic, markets fail, so government needs to fix them.

Maybe Cassidy doesn’t bear too much of the blame, because he is probably reflecting the views of a majority of economists. Particularly in that to the extent that they think about Hayek at all, it is probably through the mental prism of the A-D theory. This reflects an incomplete reading of Hayek, who did give prominence to the role of prices, and the price system that “can act to co-ordinate the separate actions of different people.” But it misses crucial parts of Hayek, indeed, what is arguably the most crucial part: the distinction between process and equilibrium:

The statement that, if people know everything, they are in equilibrium is true simply because that is how we define equilibrium. The assumption of a perfect market in this sense is just another way of saying that the equilibrium exits but does not get us any nearer an explanation of when and how such a state will come about. . . . [I]f we want to make the assertion that, under certain conditions, people will approach that state, we must explain by what process they acquire the necessary knowledge.

And one could of course find numerous other Hayek quotes where he casts aspersions on the utility of equilibrium modeling as a tool for understanding market processes; Hayek explicitly criticized the Walrasian “simultaneous equations” equilibrium approach that Arrow-Debreu put on a far firmer mathematical foundation. But Cassidy’s identification of Hayek with Arrow-Debreu is a (very depressing) signal that the critical distinction is all but lost.

The other thing that struck me is Cassidy’s simplistic, and clueless, discussion of Coase and the Coase theorem. His praise for Pigou, and his adoption of Pigou’s mental mindset, without even slightly serious consideration of Coase’s devastating critique is truly amazing. Reading this book you wouldn’t have any idea why Coase’s 1960 paper is the most widely cited in the social sciences. It is quite a trick to write a book with “market failure” in the title that almost completely ignores Coase.

And more generally, the identification of capitalism or the market economy with the perfect competition model means that Transaction Cost Economics and New Institutional Economics are completely absent from the book: Williamson doesn’t even rate a mention in the index. This means that all of the insights about non-price, non-government coordinating mechanisms that flowed from Coase’s 1937 paper, which is an essential complement to Hayek’s price-centrism, are completely lost from view.

You might object that Cassidy’s is a popular book, and thus doesn’t deserve no nevermind from highly trained professionals. :) But the book is the distillation of conventional wisdom, and in that sense, it is very revealing. Moreover, it shows that we really haven’t made much progress in decades. In Capitalism, Socialism, and Democracy, Schumpeter argued forcefully that the case for capitalism couldn’t be based on the ideal of perfect competition. He also made it clear that this model was also a defective guide to policy: “It is a mistake to base the theory of government regulation of industry on the principle that big business should be made to work as the respective industry would work in perfect competition. And socialists should rely for their criticisms on the virtues of the socialist economy rather than on those of the competitive model.” [Emphasis added.]

But reading Cassidy makes it plain that we are in the same place now as we were in the 1940s when Schumpeter wrote. The only thing that has changed is that Schumpeter focused on market power and modern critics obsess about information asymmetries. The difference is truly insubstantial.

In his devastating but polite criticism of what might be termed Stiglitzism, Vernon Smith ties together themes that can be traced back to Hayek, Coase, and Schumpeter:

The dichotomy, between the ideal and that which is empirically achievable by any mechanism, is at the heart of what was wrong with traditional conceptions and interpretations of neoclassical market equilibrium and applies with equal force to the interpretations of the new contributions. Nothing much has changed except to give us much more thoughtful and precise static equilibrium models that are more explicit about who has what dispersed information. Theorists make important contributions that need to be clearly distinguished from any rhetorical leaps to untested economic policies or general claims about market failure. (Rationality in Economics, p. 101).

On the topic of the “conventional wisdom” that this book distills, has anyone done a critical survey of introductory textbooks lately, repeating the work of a free enterprise group a couple of decades ago? At that time Samuelson’s book had just been tipped out of first place and there were some good books in use, along with a lot of bad ones. But for another decade or two Samuelson’s views spelled out in his texts of the 1950s and 1960s will probably persist in a considerable body of public opinion.